What you need to know about ETFs

Exchange-traded funds are a great way to trade markets in the short term. But before you dive in, says Paul Amery - here's what you need to know.

Do you know your market orders' from your limit' and stop-limit' orders? If you're trading exchange-traded funds (ETFs), you need to. ETFs have given fund investors a great deal more power to trade markets in the short term and that power can be harnessed or mis-handled.

Historically, most investment funds were bought and sold on a bulk, once-a-day basis, at a single price, the net asset value (NAV). This meant there wasn't much of a trading aspect to fund selection. (In practice, many fund operators added a commission or initial load' to the price payable by fund buyers, but that's tended to vanish as competition has grown.)

ETFs, by contrast, operate in real-time, just like shares and bonds. You have a bid price at which you can sell, and an offer price at which you can buy. The spread' is the gap between the two. These prices vary constantly, depending on fluctuations in the price of the underlying assets. That makes ETFs much more suitable for short-term trading as well as buy and hold'.

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So if you fancy trading them, what should you be aware of? If you log into your online stockbroking account and follow the instructions to buy and sell a particular fund, you'll be given an option to deal at best' or at market'.

When you're looking to trade in an ETF (or ETC) with great liquidity and a tight bid-offer spread, such as the iShares FTSE 100 ETF (LSE: ISF) or ETF Securities Physical Gold ETC (LSE: PHAU), you should have no qualms dealing in this way, as you're pretty much guaranteed a fair price. But it's much riskier to deal at market when a fund is rarely traded and has average spreads of a few per cent (check the London Stock Exchange website for ETFs' weekly trading data).

Here, limit orders, which allow you to specify a maximum purchase price (or a minimum sale price) are useful. Many ETF providers recommend using limit rather than market orders as a general policy.

However, even limit orders may not protect you if prices gap' that is, jump far through your pre-set buying or selling point. Here, stop-limit orders allow you to specify both a trigger point and a maximum percentage movement beyond that trigger.

In an era where sudden, extreme price movements seem to occur with alarming frequency (as happened in Apple shares on 23 March, for example), it's a good idea to make use of limit and stop-limit orders as a matter of course.

Paul Amery edits www.indexuniverse.eu , the top source of news and analyses on Europe's ETF and index-fund market.

Paul Amery

Paul is a multi-award-winning journalist, currently an editor at New Money Review. He has contributed an array of money titles such as MoneyWeek, Financial Times, Financial News, The Times, Investment and Thomson Reuters. Paul is certified in investment management by CFA UK and he can speak more than five languages including English, French, Russian and Ukrainian. On MoneyWeek, Paul writes about funds such as ETFs and the stock market.